New Tech Takes On Cost-Plus Pricing by Agencies

I have been working for a company that makes software solutions for buying digital media, and I have worked for a number of ad technology companies in the past. In a world where digital banner ads are still purchased through email and fax, and media plans are mostly created using Microsoft Excel — technology dating from 1985 — the ad technology industry sees an opportunity to create efficiencies in the way media is bought and sold.

One of the odd industry dynamics we have encountered in bringing our product to market is how independent agencies are more apt to embrace new efficiencies than some of the “big four” owned agencies that lead the space in terms of media spend.

Logically, you’d think that gigantic media agencies, managing hundreds of media planners and buying on thousands on digital media channels, would grasp at the chance to do more planning with fewer personnel, migrating towards web-based tools that offer efficiency and centralization. The evidence has shown otherwise.

On the surface, it may seem as though the biggest difference between independent agencies and the majors is size. The majors have Ford, and the independents have the Ford dealers. They both work very hard to identify digital audiences, perform against marketers’ aggressive KPI goals, while trying to understand how they got there through detailed analytics. At the core, the difference between what media teams within holding company shops and a smaller agency does is minimal. So what accounts for the reluctance of bigger shops to innovate with technology tools?

One reason may be the way they get paid.

The biggest shops consistently rely upon cost-plus pricing, which pays them based on hours worked, plus an additional, negotiated margin. The typical $500,000 digital media plan takes an alarming 42 steps and nearly 500 man hours to complete, which can cost up to $50,000 — and that doesn’t even include developing the creative.

If you are paying your agency on a cost-plus basis, your agency doesn’t have a lot of incentive to create your plan faster, or with less labor. In fact, this type of pricing scheme creates an incentive for inefficiency, or what economists call a “perverse incentive.” Unfortunately, every cent you pay towards the labor of creating a media plan subtracts from the amount that can be dedicated to the media itself.

Spend

So, what to do? The most obvious choice for those working with a large agency under such a scheme is to try and change the payment terms. Pay-for-performance is optimal, but a careful analysis may show that paying on a percentage-of-spend model yields more reach, when you are not paying for the labor of building a media plan.

Some marketers are choosing instead to build small, efficient in-house teams to leverage the demand-side technologies that their agencies want to discover and buy digital media. Other marketers choose to work with multiple smaller, independent agencies that have specific expertise in different digital verticals. Those shops usually offer flexible fee structures, and you are far more likely to work with the team that pitched you after you hire them.

As they say in finance, it isn’t what you make, it’s what you keep. In digital media, moving away from cost-plus pricing relationships and towards new technologies for media buying means keeping more of your money for reach, and spending less on labor that doesn’t help you move the sales needle.